Chapter 5
Audit Evidence and
Documentation
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Audit Risk

The possibility that the auditors may
unknowingly fail to appropriately modify their
opinion on financial statements that are
materially misstated


This is the risk that the auditors will issue an
unqualified opinion on financial statements that
contain a material departure from GAAP.
Auditors must obtain sufficient appropriate audit
evidence to reduce audit risk to a low level in
every audit.
5-2
Financial Statement Assertions
 Assertions
about account balances
(Accounts)
 Assertions about classes of transactions
and events (Transactions)
 Assertions about presentation and
disclosure (Disclosures)
5-3
Financial Statement Assertions: Auditing
Standards Board and International Standards
Accounts
Transactions
Disclosures
Existence
Occurrence
Occurrence
Rights and
obligations
Rights and
obligations
Completeness
Completeness
Completeness
Valuation and
allocation
Accuracy
Accuracy and
valuation
Cutoff
Classification
Classification and
understandability
5-4
Combined Assertions
Used in this Text






Existence or Occurrence--Assets, liabilities, and equity
interests exist and recorded transactions have occurred
Rights and Obligations--The company holds rights to the
assets, and liability are the obligations of the company
Completeness--All assets, liabilities, equity interests, and
transactions that should have been recorded have been
recorded
Cutoff—Transactions and events have been recorded in the
correct accounting period
Valuation, Allocation and Accuracy—All transactions, assets,
liabilities and equity interests are included in the financial
statements at proper amounts
Presentation and Disclosure--Accounts are described and
classified in accordance with generally accepted accounting
principles, and financial statement disclosures are complete,
appropriate, and clearly expressed
5-5
Audit Risk
Audit Risk =
=
Risk of Material
Misstatement
Inherent
Risk
*
Risk That the
Auditors Fail to
the Misstatement
*
Control
Risk
*
Detection
Risk

Inherent Risk--Risk of a material misstatement occurring in an
assertion assuming no related internal controls.

Control Risk--Risk that a material misstatement in an assertion
will not be prevented or detected on a timely basis by the
company’s internal control.

Detection Risk--Risk that the auditors’ procedures will lead
them to conclude that a material misstatement does not exist in
an assertion when in fact such misstatement does exist.
5-6
Audit Risk Formula
AR = IR * CR * DR
AR
IR
CR
DR
=
=
=
=
Audit risk
Inherent risk
Control risk
Detection risk
5-7
Audit Risk
Figure 5. 2
5-8
Inherent Risk


Factors that affect inherent risk:
 Nature of the client and its environment
 Nature of the particular financial statement element
Business characteristics indicative of high inherent risk:





Inconsistent profitability of client
Operating results highly sensitive to economic factors
Going concern problems
Large known and likely misstatements detected in prior audits
Substantial turnover, questionable reputation, or inadequate
accounting skills of management
5-9
Assertions with high
inherent risk
 Involve:





Difficult to audit transactions or balances
Complex calculations
Difficult accounting issues
Significant judgment by management
Valuations that vary significantly based on
economic factors
5-10
Types of transactions

Routine



Nonroutine



Recurring financial statement activities recorded in the
accounting records in the normal course of business
Lower inherent risk
Involve activities that occur only periodically such as the taking
of physical inventories
High inherent risk
Estimation transactions


Activities that create accounting estimates
Higher inherent risk
5-11
The Third Field Work Standard
 Third


standard of field work:
The auditor must obtain sufficient appropriate audit
evidence by performing audit procedures to perform a
reasonable basis for an opinion regarding the
financial statements under audit
Sufficient audit evidence

The quantity of audit evidence that must be obtained
5-12
Appropriateness of Audit
Evidence

To be appropriate audit evidence must be:



Relevant
Reliable
Principles—Audit evidence is ordinarily more reliable
when it is





Obtained from knowledgeable independent sources outside
the company rather than nonindependent sources
Generated internally through a system of effective controls
rather than ineffective controls.
Obtained directly by the auditor rather than indirectly or by
inference
Documentary in form rather than oral
Provided by original documents rather than copies
5-13
Reliability of Certain Types of
Audit Evidence
RELIABILITY
High
Low
TYPE
Physical
EXAMPLE
Inventory Observation
Documentary
External
External/Internal
Internal
Cutoff Bank Statement
Purchase Invoice
Sales Invoice
Client Representations
Management Representation
Letter
5-14
Types of Audit Evidence
Type
Example
Accounting Information System
The accounting records and support
for transactions and journal entries
Documentary evidence
Checks, invoices, contracts, minutes
of meetings.
Third-party representations
Confirmations, lawyer’s letters,
specialist’s reports
Physical evidence
Examination of asset
Computations
Footing, recalculations
Data interrelationships
Analytical procedures
Client representations
Representation letter
5-15
Overall Types of Audit Procedures

Risk assessment procedures


To obtain an understanding of the client and its
environment, including its internal control, to
assess the risks of material misstatement
Further Audit Procedures

Tests of controls


When appropriate, to test the operating effectiveness of
controls in preventing material misstatements
Substantive procedures

To detect material misstatements at relevant assertion level.
Substantive procedures include (a) analytical procedures, (b)
tests of details of account balances, transactions and
disclosures
5-16
Substantive Procedures
 Analytical
procedures
 Tests of details
• Tests of account balances
• Tests of classes of transactions
• Tests of disclosures

One may change the scope of audit
procedures by changing the (NTE, or reordered as NET):
• Nature (type and form)
• Timing (when performed)
• Extent (quantity of evidence obtained)
5-17
Nature and Timing of Procedures
Holding the extent of procedures constant,
one may increase the scope of procedures
(make them more effective) by either
changing the

Nature-- obtain more reliable evidence
• often externally generated evidence.

Timing--wait until year-end to obtain evidence from
entire set of transactions as contrasted to performing
interim testing, say two months prior to year-end and
simply updating those procedures.
5-18
Extent of Procedures
Holding other factors such as the nature
and timing of procedures constant:



The greater the risk of material misstatement,
the greater the needed extent of substantive
procedures
The main way to increase the extent of audit
procedures is to examine more items
Sample sizes should reduce detection risk so
as to restrict audit risk to a low level
5-19
Analytical Procedures (1 of 2)

Steps involved





Develop expectation of account (or ratio) balance
Determine amount of difference that can be accepted without
investigation
Compare the company’s account (ratio) with the expectation
Investigate and evaluate significant differences
Developing an expectation





Prior period information
Anticipated results
Relationships among elements of financial information within a
period
Industry information
Relationships between financial information and relevant
nonfinancial data.
5-20
Analytical Procedures (2 of 2)

Types of Expectations
 Trend analysis—analyze changes in accounts of a
company over time
 Ratio analysis – compare relationships between two
or more financial statement accounts or comparisons
of account balances to nonfinancial data
• Liquidity (e.g., current ratio)
• Leverage (e.g., debt to equity)
• Profitability (e.g., gross profit percentage)
• Activity (e.g., inventory turnover)
5-21
Ratio Analysis
 Approaches

to ratio analysis
Horizontal analysis
• Review ratios over time

Cross sectional analysis
• Analyze ratios of similar firms at a point in time

Vertical analysis
• Analyze relationships within a period
• “Common size” statements prepared

Other methods
• Regression analysis, reasonableness test
5-22
Identifying Potential Misstatements
5-23
Basic Approaches to Auditing
Accounting Estimates
 Review
and test management’s
process for developing the estimate.
 Independently develop an estimate
to compare to management’s
estimate.
 Review subsequent events or
transactions bearing on the
estimate.
5-24
Auditing Fair Values

Inputs to use in applying valuation techniques (FAS
157)
 Level 1 – inputs of observable quoted prices in
active markets for identical assets or liabilities
• Ex. A closing stock price in WSJ

Level 2 – inputs of observable quoted prices,
generally for similar assets or liabilities in active
markets
• Ex. Company discounts future cash flows on its not
publicly traded debt securities at rate used by market for
publicly traded debt securities

Level 3 – inputs that are unobservable for the
assets or liability
• Ex. A private company uses judgment to determine a proper rate to
discount the future cash flows of its not publicly traded securities
5-25
Related Party Transactions
 Disclosure
requirements must be met
 Primary challenge is identifying
undisclosed related party transactions

Determine related parties
• Inquiries of management
• Review SEC filings, stockholder’s listings and
conflict-of-interest statements

Be alert for transactions with related parties
and any transactions with unusual terms
5-26
Functions of Audit Documentation

Primary functions:
Support the auditors’ compliance with auditing standards
• Support the auditors’ opinion
•

Secondary functions:
Assist continuing and new audit team members in
planning and performing the audit
• Serves as a record of matters of continuing audit interest
• Assists in supervision and review of the audit
• Demonstrates the accountability of team members
• Assists internal reviewers, external peer reviewers,
PCAOB inspectors, and successor auditors in performing
their roles
•
5-27
Sufficiency of Audit Documentation

Audit documentation should be sufficient to:




Enable an experienced auditor to understand the
work performed and the significant conclusions
reached
Identify who performed and reviewed the work
Show that the accounting agree or reconcile to the
financial statements
Audit documentation should include all
significant audit findings and the actions
taken to address them
5-28
Types of Working Papers









Audit administrative working papers
Working trial balance
Lead schedules
Adjusting journal entries and reclassification
entries
Supporting schedules
Analysis of a ledger account
Reconciliations
Computational working papers
Corroborating documents
5-29
Types of Working Files
 Current


files
Current year working papers
Index and cross-referencing
 Permanent

files
Items of continuing audit
interest
5-30
5-31
Preparation of a Working Paper –
Figure 5.8
5-32